MLP Profits: Get Huge Dividend Yields and Pay No Taxes

Just login with your email address to instantly generate a PDF of this content.

MLPs have rallied for the same reasons that first induced us to launch this service. Number one is generous yields backed by strong businesses that are systematically increased over time. Number two is the fact that those yields are tax advantaged at a time when the risk of higher taxes is at its greatest in decades.

MLPs offer investors a simple value proposition: double-digit, tax-advantaged yields and strong recession-resistant growth potential. Although the group has seen a nice run-up in recent months, most MLPs continue to trade at significant discounts to historical norms in terms of yields relative to other income producing groups such as high-yield bonds and real estate investment trusts (REIT).

Where I work – KCI Investing – word travels fast when a special event for investors is scheduled. So, when I heard that utility and dividend expert Roger Conrad and energy expert Elliott Gue were planning – on June 16th – to reveal their four favorite high-yield and (virtually) no-tax energy master limited partnerships (MLPs) in a one-hour audio conference call, I got really excited. Why? — because I know Roger and Elliott personally and they are two of the smartest investors on the planet. Their MLP Profits investment service may only be a little more than a year old, but so far its recommendations are outperforming the S&P 500 by a very wide margin. An annual subscription to the service costs hundreds of dollars, but this audio conference costs only a fraction of that and provides participants with Roger and Elliott’s top four recommendations. It’s like getting the best part of MLP Profits at a huge discount.

I’m getting ahead of myself. What is an MLP and why is it such a great investment choice?

A MLP is a pass-through entity for tax purposes, meaning that it does not pay any tax at the corporate level. All distributable cash flow is passed through to the limited partners. This means that the MLP does not suffer from the “double taxation” regular corporations must pay (i.e., corporate tax at the corporation level and income tax at the shareholder level). Cash flow from a MLP is taxed only once at the limited partner level. This means that there is more cash flow available for partners of a MLP than there is for shareholders of a corporation. The result is that MLPs can provide limited partners with more cash.

But the benefits of MLPs don’t stop at a higher yield. The yield of MLPs is also tax-deferred. Due to high depreciation and amortization charges, which are non-cash charges against income, up to 90% of the cash distribution made by a typical MLP to its limited partners is considered a return of capital. A return of capital is not taxable. Consequently, the portion of the cash paid out by the MLP that is a return of capital is deducted from the cost basis of an investor’s partnership units (they aren’t called shares) and tax is only due if the investor sells the shares, which could be never. Exception: if the cost basis of a unit falls to zero, all cash distributions afterwards are taxed as capital gains.

The 10% of the MLP distribution that is net income is taxed at ordinary income tax rates and is not eligible for reduced dividend tax rate treatment (c’mon, MLPs can’t have everything!). Look at the following illustration, which assumes a $50 share/unit price, a 100% net income payout ratio, 90% return of capital for MLPs, 15% tax rate on corporate dividends, and 35% ordinary income tax rate:

Benefits of No Double-Taxation and Tax-Deferral

Corporation

MLP

Taxable Income

$5.00

$5.00

Corporate Tax (35%)

$1.75

(35%*$5.00)

$0

(0%*$5.00)

Entity Net Income

$3.25

$5.00

Income Tax (15% dividend or 35% ordinary)

$0.49

(15%*$3.25)

$0.18

(35%*10%*$5.00)

Net Income to Share/Unit Holder

$2.76

$4.82

After-Tax Yield

5.5%

($2.76/$50)

9.6%

($4.82/$50)

The tax advantage of the MLP structure will be even greater if Congress does not extend the reduced 15% tax rate for corporate dividends.

History of MLPs

The first MLP was established in 1981. The obvious tax benefits from the structure caused many corporations to convert to MLPs in the next few years. The U.S. Congress didn’t like the lost tax revenue, so in 1987 it restricted the types of businesses that could become MLPs to those that generate 90% or more of their income from natural resources (including oil and natural gas), real estate, and commodities. The Congress felt that it was in the public interest to promote the growth of these special business types through tax breaks. Why not take advantage of these government-sponsored tax breaks by investing in MLPs? The U.S. government is literally throwing money at investors who do!

Tax Deferral Comes with Tax Complexity

The downside of the tax savings is that unit holders, as limited partners, receive Form K-1 from the IRS instead of the usual Form 1099 for dividends received by shareholders. Form K-1 is more complex to report on your tax return than Form 1099 and may require the filing of state income tax returns in each state that the MLP operates. But any tax accountant worth his salt knows how to report these K-1s in his sleep, so this “problem” only applies to the do-it-yourself tax preparer.

Removing Tax Complexity Could Raise Your Taxes

You can avoid this complexity by purchasing MLPs through an ETN — like JPMorgan MLP Index(NYSE: AMJ), UBS E-TRACS Alerian MLP Infrastructure(NYSE: MLPI), or Credit Suisse Cushing 30 MLP Index(NYSE: MLPN) – or through a closed-end fund – like Kayne Anderson MLP Investment Company(NYSE: KYN) or MLP & Strategic Equity Income Fund(NYSE: MTP). ETNs and closed-end funds report MLP cash distributions on Form 1099 and require the filing of only one state tax return.

There are some negatives to these fund alternatives, however. With regard to ETNs, in a taxable account you lose the tax-deferral advantage of MLPs (all cash distributions from ETNs are taxable as ordinary income), but this can be mitigated by placing MLP ETNs in a tax-deferred retirement account (e.g., IRA or 401k). The rule of thumb is to place individual MLPs in a taxable account and MLP ETNs in an IRA or 401k retirement account. With regard to closed-end MLP funds, the tax characteristic (i.e., return of capital, dividend, or ordinary income) of cash distributions is less certain, so you need to check with each closed-end fund before deciding which type of account to place it in.

Second, ETNs do not actually hold individual MLPs, but simply promise you a return based on such MLPs. Consequently, an ETN investor is subject to the credit risk of the issuer. Third, closed-end funds can trade at significant premiums to the net asset values of the MLPs they own, resulting in you purchasing $1.00 worth of MLPs for $1.15 or more, which is a bad bet to make. Lastly, buying MLP funds (ETNs or closed-end) lowers your cash yield by the amount of fund management fees and forces you to own many MLPs that may be mediocre.

Not all MLPs are Created Equal

Currently, there are more than 100 MLPs trading in the U.S. with the vast majority of them (78% by number) focused on energy (88% by market cap). Roger and Elliott at MLP Profitsrate every single MLP that exists and have sell ratings on almost a third of them. For example, Roger and Elliott have a sell rating on K-Sea Transportation Partners (NYSE: KSP), a tank barge and tugboat company operating in coastal US waters.

To merit a buy rating from Roger and Elliott, a MLP must get passing grades from a number of criteria:

When we research a particular MLP, we look at distribution track record, management’s strategy and effectiveness, age of assets, percentage of capital spending devoted to growth as opposed to maintenance and the location of the assets themselves. The result is a comprehensive assessment of potential risk and reward.

To sum up, despite the significant tax advantages enjoyed by MLPs, not all MLPs are worthy of your hard-earned investment dollars. Managing your own portfolio of individual MLPs with the guidance of MLP Profitsallows you to concentrate only on the very best MLPs and maximize your potential gains.

MLP Outperformance Has Been Extraordinary

The performance of MLPs in both the long-term and the short-term has been amazingly good, outperforming the S&P 500 over virtually any time frame you can find. Look at the performance of MLPs over the past ten years:

Source: Bloomberg

On price alone, MLPs outperformed the S&P 500 by more than 220 percentage points! But this does not include the huge cash distributions investors received. If you take into account reinvested cash distributions, the outperformance explodes to 517 percentage points! Amazing.

MLP outperformance has continued in the short-term as well. In the October 2007 to March 2009 bear market, MLPs’ total return outperformed the S&P by more than 16%:

Source: Bloomberg

And in the subsequent bull market from March 2009 to May 2010 MLPs outperformed by 19%:

Energy Prices Should Remain High

Of course there’s no guarantee this outperformance would continue if energy prices were to enter a sustained decline and MLP cash distributions followed suit. But energy expert Elliot Gue is confident that energy prices are primed to rise, not fall. In fact, “the end to easy oil” is one of Elliott’s favorite long-term investment themes:

Supply concerns are at the heart of the end of easy oil. Production from easy and cheap-to-produce large onshore fields with less- complicated geology will be replaced with more expensive-to-produce offshore fields. That translates into rising marginal costs for crude oil production and elevated oil prices to incentivize the massive investment needed to produce oil sands and deepwater projects.

MLP Valuations Look Good

Demonstrated historical outperformance and positive long-term future trends are important, but a convincing case for investment in MLPs also requires evidence that they are not overvalued. Fortunately, Elliott wrote just two months ago that MLP valuations remain attractive compared to other high-yield alternatives:

Not only does the Alerian MLP Index offer a higher absolute yield compared to the bond markets and REITs, but the index also looks cheaper on the basis of historical yields than these other two income-oriented investments. It appears that MLPs continue to offer investors attractive yields without too much additional risk. Although we can’t rule out the occasional correction for the group, it certainly doesn’t appear that MLPs are trading at particularly demanding valuations as a group. Much of the past year’s rally simply reflects a normalization of valuations after a period of extreme undervaluation during the financial crisis.

Add Some MLPs To Your Portfolio!

The U.S. government has a public policy of promoting energy infrastructure. To further this goal, it provides generous tax benefits; it wants investors to make lots of money investing in MLPs. Don’t look a gift horse in the mouth; take the government’s money!

With the Alerian MLP Index currently yielding over 7%, now is a great time to add some tax-advantaged MLPs to your portfolio. In fact, you can do even better than the index yield. Roger and Elliott have found some MLPs they like that pay over 10%! A good way to get started would be to listen in to Roger and Elliott’s one-hour audio conference call on June 16th, where they will reveal their four favorite MLPs right now.

Our Stock Talk section is reserved for productive dialogue pertaining to the content and portfolio recommendations of this service. We reserve the right to remove any comments we feel do not benefit other readers. If you have a general investment comment not related to this article, please post to our Stock Talk page. If you have a personal question about your subscription or need technical help, please contact our customer service team. And if you have any success stories to share with our analysts, they’re always happy to hear them. Note that we may use your kind words in our promotional materials. Thank you.

Hopelessly overeducated, Jim holds a bachelor's degree from Yale University, a master's degree from Harvard's Kennedy School of Government, a law degree from Columbia University, and an MBA from the University of Virginia's Darden School of Business. For good measure, he has been a member of the Illinois and D.C. bars and is a CFA charterholder.

Prior to joining Investing Daily, and when not incurring student loans hiding out in academe, Jim practiced telecommunications regulatory law for nine years until he realized that he made more money trading stock options than writing briefs. After attending business school, Jim switched gears to the investment realm full-time, working for a university endowment, a private wealth management firm, an insurance and financial planning company, and as a Senior Analyst for an online investment newsletter service that encourages the wearing of funny hats.

A possible but unlikely descendant of legendary brawler and boatman Mike Fink, Jim defies his heritage, believing that investing success requires patience and analysis, not swashbuckling bravado. Besides his passion for analyzing and writing about stocks, Jim likes to hike in the desert Southwest, vacation in Las Vegas, play tennis, and feed his toddler son Cheerios.

Investing Daily is not a registered investment advisor or broker/dealer. All information provided on the Investing Daily network of websites is provided as-is and does not represent personalized investment advice. These sites do not constitute a representation by the publisher or a solicitation for the purchase or sale of securities. All opinions provided are based on sources believed to be reliable and are written in good faith, but no warranty or representation, expressed or implied, is made as to their accuracy. There are risks associated with any investment and we strongly encourage readers to supplement the information in these articles, special reports, and newsletters with independent research and other professional advice before investing in any security.